seeking alpha

There’s a confusing dynamic happening in the software industry caused by the inexorable shift to the cloud. Even before you can get into the analysis you need to identify which cloud(s) you’re thinking about (infrastructure, apps, platform). Also, once you’ve done that you need to decide if you’re partial to technology or financial analysis. It should be no surprise that either approach alone gives only half the picture, so you really need to engage on both fronts.

A big topic right now centers on whether vendors are growing their revenues fast enough to claim leadership positions in the cloud. If not, what happens to those not growing fast enough to satisfy the finance guys. Oracle is a case in point and the company has been subject to a lot of financial analysis that finds the company lacking. How you evaluate revenues, especially in comparison to peers helps you figure out the price of a share of stock. But it’s very hard to get to an apples-to-apples comparison.

As one recent post on Seeking Alpha declared, “Oracle’s ability to adapt to the decline of the on-premises software business and the rise of cloud/SaaS remains in question.” To which I say maybe because the analysis is only partly revenue related. Of equal importance is the changing revenue model—taking in incremental revenue rather than a big license fee.

Moving to the cloud changes the business model, not just the product and too often I see financial analysts applying old financial models to new technology and business models and it doesn’t work well.

For most companies the easiest customer to re-sell or up sell is one you’ve sold to before but migrating your installed base to the cloud is anything but easy if you sold them legacy solutions. The effort is more akin to selling for the first time. No decision which can be frustrating in any sales situation is just as prevalent in an installed base as it is in the general market even for an incumbent vendor.

So in the horserace that some financial analysts insist on handicapping, a pure cloud vendor will usually look better than a legacy vendor moving there. But on top of all that, when your analysis is based on revenue growth you can get spurious results. Even if a legacy vendor induces an existing customer or a group of them to convert, the revenue impact is likely to be a short-term reduction because we recognize cloud revenue over time, not all at once.

We are unarguably in a transition-state so we see a mixed industry. But if you go down the road a few years to a time when the major conversion from legacy to cloud is over, the whole industry will look more uniform and comparisons will be easier.

But it will also be a more fragmented market than we have now. Software vendors will have many complex relationships between themselves and infrastructure vendors and it will be far from unusual for Brand A software to be running on Brand B infrastructure even though both brands might offer both software and infrastructure.

All of this suggests to me that the real plain of competition will have to change. It will change because the vendor communities want to avoid the zero-sum rut that markets invariably head towards in a commoditization push that leaves the survivors competing for pennies when they once competed for millions.

That’s why I see the industry morphing into a utility where a small oligopoly controls most aspects of the market, usually under some form of regulation. A utility won’t care much about infrastructure, for instance, because it will all be the same from the perspective that it adheres to standards.

The electric utility industry is a fitting example. Electric devices are agnostic over how power is generated or whether it comes from next door or a thousand miles away though some customers might prefer greener or cheaper solutions. But vendors in the supply chain take responsibility for adhering to and maintaining standards so that the product is uniform.

Last word

It’s doubtful at this stage if any of the enterprise software vendors will stub a toe getting to the cloud. Each has a unique path to travel that’s based on history and legacy constraints. At this point, rather than comparing vendors in what is a very disparate market, it might be wise to look more at year-over-year comparisons and similar measures that track a vendor’s progress against the goal. Revenues and revenue growth will, of course, always be important but the handwringing that goes into quarterly analysis and that emanates primarily from looking at a still emerging market and seeing a long established one, obscures reality and benefits no one.

Financial analysts are in a small funk because Oracle’s earnings were not as spectacular as they’d have liked. Actually, the revenue numbers were fine; they beat the street estimates of $9.57 billion for the just completed Q2 2018 with revenues of $9.63 billion. The cause of the consternation was a relatively weak cloud growth rate of “only” 44 percent after posting 51 percent growth in the prior quarter. That’s a downward trend and thus the consternation. What explains this?

Let’s focus on human nature. Financial analysts look for eye-pleasing graphics and numbers that tell wonderful stories of increase. But the reality is always more complicated. Orders don’t ship, customer CTOs get cold feet, CEOs find new bright and shiny objects to pursue. Stuff happens. As a result, often a vendor’s numbers don’t’ look as impressive as we’d like.

One specific area of concern for Oracle has been the speed at which the market is adopting its IaaS and PaaS (infrastructure and platform) product lines. The SaaS line seems to be good. Oracle sold $1.1 billion of SaaS in Q2 making it one of the biggest SaaS companies on the planet. But it’s still struggling with infrastructure and platform which combined brought in “only” $396 million in the quarter.

The SaaS business seems to be new deals won the old fashion way. But it takes more effort to grow the other two because much of the increase is logically expected to come from Oracle’s customer base. Analysts are expecting existing customers to swarm in to the new offerings but they seem to be taking their time. The maxim, if it ain’t broke, don’t fix it comes to mind.

Most enterprises have a huge investment in hardware and software, which they are naturally reluctant to discard. So while Oracle’s offer to let them migrate their existing licenses to the cloud in a program called BYOL or bring your own license, that offer is not sweet enough for many businesses with gear they’re still writing off.

At this rate it will take more than the efficiencies from better infrastructure to motivate many businesses to move, hence the disappointing numbers. But to be a bit more realistic, customers are moving to the cloud—$396 million is far from nothing. But it’s going to take more time than the optimists thought to get the migration moving at a faster clip.

At this point there are many things Oracle can do. First, it should count and publish the numbers of businesses coming to their infrastructure. This will likely represent customers gaining a toehold in the cloud. They’ll bring one application or department to the cloud as an experiment and Oracle should pay attention to this because it’s one sure method of growth.

Even if the revenue numbers are small the absolute number of businesses going to the cloud, even if only partially, will strongly suggest future acceleration. For all we know such information is already embedded in the $396 million Oracle already reported. Second, Oracle can sell platform. They do this already but perhaps some effort more squarely aimed at the small developer groups that just need a sandbox. That’s where early growth often comes from. Those groups are often oriented to Microsoft products running on AWS so the strategy works well in two directions. Lastly, when all else fails, the financial analysts could always try being a bit more patient.

My 2 bits

Moving to the cloud is an arduous event for any company. It calls for managers to tinker with the secret sauce, something they loathe. So it’s no surprise to me that moving is a slow process and that despite having all of the bells and whistles ready to go, Oracle is still in early market hurry up and wait mode. It can’t be helped—no vendor can expect to sell anything until it produces the whole product. Oracle CEO Mark Hurd is famous for saying they’ve built a skyscraper but couldn’t start renting units until the building was finished. That’s the time when financial backers begin asking about revenues.

But it takes more time than we care to admit to make a cloud. Oracle is showing some promising signs of early adoption but the situation still calls for patience.

Oracle reports its earnings on Thursday, December 14, after the markets close and trying to guess how the company did in its second fiscal quarter has become a parlor game. Seeking Alpha, an investment newsletter, has been making observations ahead to the announcement trying to inform its subscribers about what to expect. They are not alone, financial analysts do this. But the thing that amazes me is how little the financial analysts understand the shift taking place both at Oracle and throughout the industry.

Lots of people seem to be clucking over how much the company has invested—$22+ billion or just under 15 percent of all revenues over the last four years. At the same time Seeking Alpha notes that annual revenues have been flat as a medieval map of the world fir quite a while—stuck at about $38 billion.

The good news, they say, is that cloud revenues have grown at 12.36 percent per quarter while on-premise revenue declined at 1 percent. Meanwhile hardware sales over the last 2 quarters have dropped about 2.5 percent per quarter for the last 2 years. All this despite some world beating computing and storage services. You can find all of the stats here.

Now, it’s expected that the finance guys are always going to want to know about profits and growth and any big time capitalist manager is going to both understand this need and desire to meet expectations. As a technology analyst, I am not either guy and my capitalist instincts are in check whenever I look at a situation where a new industry and product lines are being developed as is the case here.

Consider first what it will take for Oracle to begin making real money on its investment in the cloud. First step in any such situation is to diffuse the new or disruptive innovation to the marketplace. For Cable TV, telephone, and electricity it took decades of stringing wires and opening offices to reach something close to market saturation. Oracle or any cloud provider is piggy-backing on earlier investments in the Internet so scratch that.

But add in some huge investments in data centers around the world that support Oracle’s cloud. Also add the cost of R&D and acquisitions that produce the actual apps that enterprises need and you can easily see how the company spent billions. At the same time, the crowd of users Oracle wants to attract is still in the sales funnel. Oracle’s more than 425,000 customers are primarily on-premise users and they are conscious of the cloud move and many are therefore planning their shifts; they are not investing in a lot more on-premise products as the numbers bear out.

So Oracle is in a classic squeeze having paid out all or a very substantial part of the investment and they’re still waiting for the returns. This understandably makes the finance guys somewhat concerned and although it’s their job to seek profits they don’t show a great deal of sophistication in understanding the major trend that moving to the cloud drives.

Seeking Alpha expects graphs of Oracle’s cloud and on-prem businesses revenues to intersect in 2020. That means continued slow downward trending for the on-premise business and very nice up ticking for the cloud. As a long-term viewer it looks pretty good to me. But I can certainly understand how widows and orphans might not.